The Plight Of The Bank Depositor Today

We at The Real Asset Company have long had concerns with the amount of leverage or debt in the banking system we coexist with. To us the financial institutions of today appear like a series of spinning tops, spinning and balancing on a small capital base and thus vulnerable to exogenous shocks. Levels of leverage had been growing for some time as financial institutions employed more risk to outperform their competitors and achieve higher returns for stockholders.

The number of European sovereigns and banking institutions that today appear more like wobbling and oscillating tops at significant risk of falling over has got us thinking again about bank depositors who play a very significant role in funding this banking system. We cannot help but feel these depositors are an unfortunate, under-appreciated lot, who bear more risk than they potentially appreciate and for a potentially inequitable return.

The current crisis is often described as a balance sheet recession and it is also the balance sheets of many of the world’s large and systemically important financial institutions that are vulnerable. Maybe even your bank.

Raising capital has become an on-going concern for bank boards as they struggle to meet Basel III and other such regulatory capital requirements; even in a world where mark-to-make-believe seems to have become an more commonplace accounting method than it should in, forgoing the discipline that proper mark-to-market asset valuations brings.

Yet what are the capital foundations that these banks depend on to operate their leveraged structures and complex balance sheets, often so complex that their management don’t fully understand their true assets and liabilities?

Well, apart from apparently liquid and high quality assets such as triple A or highly rated debt whether it be sovereign, corporate or other, the deposits and savings of individuals, families and businesses form perhaps the most significant part of this foundation capital. These deposits and savings are real wealth and act as the keystone of the banking system.

We all know that in return for leaving your cash or savings in a bank you receive an interest return on your money. This return is to compensate you for lending this money to the bank for their commercial enterprises where they seek to earn a higher return than they need to pay you in interest.

As long as the bank earns a greater return in its business dealings than it is required to pay you, a return on equity is achieved. Savings in a bank do not deliver the depositor a risk free rate of return. We also know that an investor seeks to balance risk with reward in his endeavours, so we pose the question. Does keeping deposits and savings in a bank represent a favourable risk-reward equation?

To put this discussion in a little more context we bring in one of our favourite analysts and commentators, Eric Sprott. Eric has over three decades of investment experience and is the founder of the now $10bn Sprott Asset Management. His hedge fund has achieved yearly average returns of greater than 20% each year for over a decade. In his July report, The Real Banking Crisis, Eric continues with an apparently shared theme; that there is simply too much leverage employed in our contemporary financial system. Eric draws our attention to the data released every Friday concerning US bank failures.

When you compare the failed banks’ assets to the cost the FDIC pays to make their depositors whole, it reveals how many times the banks have lost their equity capital. The key to remember here is that banks lend out our money and keep very little in reserve. If we assume they keep 5 cents of capital for every 95 cents they loan out. A 25% implied write-down… would mean that the bank has effectively lost its capital six times over.

The banking situation in Europe is no different… EU banks are also highly levered, but their situation is further complicated by the fact that what was once the most liquid and secure loan on European banks’ balance sheets, sovereign debt, is no longer liquid and secure. – Sprott Asset Management

This makes EU banks extremely vulnerable to deposit withdrawals as it forces them to approach the ECB for help to maintain liquidity. There is only so much the ECB can do. If a true liquidity event takes place, we can all rest assured that there will be no buyers of distressed assets in the sizes that European banks hold today, sovereign bonds, or not.”

It appears that certain failing banks have not just been entering bankruptcy having lost their depositors’ assets, but many times the value of these assets. Anyone who has invested with even a penny of margin should understand what is happening here. The banks are employing so much leverage in their operations that they are hugely exposed to downward movements in financial asset prices.

One should be reminded that the more leverage one employs in an investment position, the more exposed one is to price movements up and down. Greater leverage brings greater directional exposure. A more highly leveraged bank balance sheet can thus only bring the bank and its depositors greater risk for their participation in the financial system.

We ask rhetorically is this a stable model to use within a banking system on which we all depend? We were pleased to see such a high profile steward of the financial system, Lord Adair Turner of the FSA, question whether higher capital ratios of close to 33% would be a more prudent and stable operating model in the summer of 2010.

To return to today’s discussion of keeping money in a bank, with bank failures a real and attendant risk that has shown little evidence of mitigating this last few years, are depositors being fairly rewarded and why would one chose to keep significant amounts of their net wealth in a bank? As financial institutions have moved away from more prudent business models in the effort to achieve greater returns on equity they have taken on more risk.

The levels of leverage at work on Wall Street and in The City of London have grown since the 1970s to be knocking in the door of a 40:1 ratio prior to 2008’s Credit Crunch, but the commercial banking world is also leveraged to about 20:1 according to Eric Sprott in an interview with Bloomberg on 12th May this summer. But are depositors receiving a greater or even remotely proximate reward, and interest return, for bearing part of this greater risk level? We would urge that they are not.

In today’s new normal, depositors have to accept little interest income, and are actually having their wealth eroded by punishing levels of inflation. Inflation hit 5.6% in the UK this week according to The Bank of England. Where is all this inflation coming from one might ask? Being openly Austrian in economic mind-set, we would urge that this inflation is a purely monetary phenomenon; quite simply, a greater amount of money chasing a steady amount of things (asset, goods, services etc) means that prices can only rise.

The monetary authorities of the world have been printing money and increasing the money supply to provide emergency liquidity to the banking system in an effort to combat years, maybe even decades if you have an affiliation with George Soros’s Credit Super-Bubble thesis of malinvestment and misallocation of capital caused by the excessively easy availability of credit.

The depositor who funds a great deal of the very basis of the whole banking system appears to get an inequitable interest return and may not be aware of the vulnerability of the balance sheet and assets of his own bank. Deposits really are the foundations here that allow banks to engage in their other potentially less socially useful and certainly more risky operations.

For example, Bob Diamond is so keen to keep Barclays’ commercial bank within the umbrella of the greater Barclays banking group so that the commercial bank’s huge deposit base can be leveraged and used in the overall goal of generating greater returns on the bank’s equity.

To continue the discussion we turn to the perhaps unlikely contributor to things financial, Ricky Gervais (bear with us, there is a point coming!). In his latest stand-up show, Science, he comments.

It was only last year I found out you can go into your bank and say can I withdraw my cash, and they can say, no, we ain’t got it. – Ricky Gervais

Whilst part of a comedy show, Ricky’s frustration with this explanation reveals the larger dynamics at work here and is perhaps an example of the wider public gradually starting to appreciate what the leveraged nature of today’s fractional reserve banking system means for their savings deposits. Ricky’s sentiments also align with Mervyn King, the Governor of the Bank of England and another high profile steward of our current financial system, who in October 2010 commented that “of all the many ways of organising banking, the worst is the one we have today”.

Ricky Gervais’ experience is merely that of the concerned saver who had gone to his bank to ask for the return of his money at a time of financial stress when he felt he needed it most. Whilst asking your money to be returned in cash form brings its attendant logistical challenges for the delivering bank, the fact is that were all the depositors of his bank to ask for their money back in cash or electronic form there would be a run on this bank and some depositors would not get their money back.

The term bank run is an emotionally loaded term that brings all sorts of fears with it, but why should a banking system be so vulnerable to events where people simply want their money back? We would urge that the combination of too much leverage combined with depositors not really understanding the nature of the arrangements you enter into when you save money with a bank, is problematic.

Depositors need to be aware that keeping money in a bank carries risks, and that interest income and the return of your money cannot be guaranteed. You are lending your savings to a financial counter-party and are thus dependent on the operational and commercial success of this counter-party for the safety of your deposits and the interest income you hope to receive. Investors remembered to worry about the return of their capital before the return on their capital as the Credit Crunch hit.

We would therefore question whether keeping money in savings accounts within highly leveraged banks represents the safe and suitable savings mechanism they are widely treated as. Holding savings within banks in whatever form is not an exercise in achieving risk free returns, because your asset is simultaneously the liability of your bank.

It is this fact that we would urge savers and investors to reconsider, and then think whether there are in fact other financial assets out there that are completely free of such counter-party risk and thus represent a potentially superior savings mechanism.

If our thesis holds water and is taken as acceptable, what then where is the saver to turn? Ever heard of gold and silver bullion?

Will Bancroft regularly contributes to investment and finance sites such as Market Oracle, Seeking Alpha, Stockopedia, Renegade Economist and more. His passion for politics, philosophy and economics led him to develop a keen interest in Austrian economics, gold and silver. Read more of his articles.

Please Note: Information published here is provided to aid your thinking and investment decisions, not lead them. You should independently decide the best place for your money, and any investment decision you make is done so at your own risk. Data included here within may already be out of date.

About the Author

Will BancroftWill Bancroft is Co-Founder of The Real Asset Company, a market place for individuals to invest in gold, silver and precious metals. Will also contributes commentary and analysis to the Research Desk. His interest in financial markets and investment led to a keen interest in monetary economics, gold and silver. Will is passionate about gold’s role in a portfolio and his views appear on sites and media such as Kitco, Market Oracle, Seeking Alpha, Stockopedia, The Telegraph and Yahoo Finance. Follow Will on Google+, and get his commentary via our RSS feed.View all posts by Will Bancroft